Principles of Economics-1

Principles of Economics (MPE 007)
STUDY PACK
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FOREWORD
This study pack covers all the topics and all the basic materials necessary for adequate grasp of
the subject for the Proficiency Certificate in Management Examination of Nigerian Institute
of Management (Chartered).
While expecting candidates to read as widely as possible on their courses, the Institute's aim in
preparing this study pack is to treat in one publication all the topics covered by the syllabus
for this particular course.
This will enhance focused study on the part of candidate. This pack is written by an expert
on the subject. The writing is reader-friendly while the issues discussed are current with the
general treatment of topics having a contemporary feel.
The topics are treated in a way not only to provide general and theoretical knowledge but to
enhance practice.
We wish to express our utmost appreciation to our faculty of experts for their invaluable
development and writing of these study pack series.
We also appreciate the support provided by the Directorate of Capacity Building.
MANAGEMENT
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TABLE OF CONTENTS
Pages
Basic Economic Concepts............................................1– 9
Theory of Consumer Behaviour....................................10 – 14
Production Cost and Theories.......................................15 – 28
Price System..................................................................29 – 42
The Theory of the Firm...................................................42 – 51
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CHAPTER ONE
I. BASIC ECONOMIC CONCEPTS
a. Nature and Scope of Economics
Economics is the science that deals with production, exchange and consumption of various
commodities in economic systems. It shows how scarce resources can be used to increase
wealth and human welfare. The central focus of economics is on scarcity of resources and
choices among their alternative uses. The resources or inputs available to produce goods are
limited or scarce. This scarcity induces people to make choices among alternatives, and the
knowledge of economics is used to compare the alternatives for choosing the best among
them. For example, a farmer can grow cassava, sugarcane, banana, yam etc. in his garden
land. But he has to choose a crop depending upon the availability of irrigation water.
Two major factors are responsible for the emergence of economic problems. They are:
i) the existence of unlimited human wants, and
ii) the scarcity of available resources to satisfy those wants.
The numerous human wants in (i) are to be satisfied through the scarce resources available in
nature indicated in (ii). Economics deals with how the numerous human wants are to be
satisfied with limited resources. Thus, the science of economics centres on want - effort -
satisfaction. It not only covers the decision making behaviour of individuals, but also the
macro variables of economies like national income, public finance, and international trade.
Definitions of Economics
Several economists have defined economics taking different aspects into account. The word
‘Economics’ was derived from two Greek words, oikos (a house) and nemein (to manage)
which would mean ‘managing an household’ using the limited funds available, in the most
satisfactory manner possible.
i) Wealth Definition
Adam smith (1723 - 1790), in his book “An Inquiry into Nature and Causes of Wealth of
Nations” (1776) defined economics as the science of wealth. He explained how a nation’s
wealth is created. He considered that the individual in the society wants to promote only his
own gain and in this, he is led by an “invisible hand” to promote the interests of the society
though he has no real intention to promote the society’s interests.
Criticism of Adam Smith definition

Smith defined economics only in terms of wealth and not in terms of human welfare. Ruskin
and Carlyle condemned economics as a ‘dismal science’, as it taught selfishness which was
against ethics. However, now, wealth is considered only to be a mean to end, the end being
the human welfare. Hence, wealth definition was rejected and the emphasis was shifted from
‘wealth’ to ‘welfare’.
ii) Welfare Definition

Alfred Marshall (1842 - 1924) wrote a book “Principles of Economics” (1890) in which he
defined “Political Economy” or Economics is a study of mankind in the ordinary business of
life; it examines that part of individual and social action which is most closely connected with
the attainment and with the use of the material requisites of well being”. The important
features of Marshall’s definition are as follows:
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a) Economics is a study of mankind in the ordinary business of life, i.e., economic

aspect of human life.
b) Economics studies both individual and social actions aimed at promoting economic
welfare of people.
c) A distinction between two types of things, viz. material things and immaterial things.
Material things are those that can be seen, felt and touched, such as book, rice etc. Immaterial
things are those that cannot be seen, felt and touched such as skill in the operation of a
thrasher, a tractor etc., cultivation of hybrid cotton variety and so on. In his definition,
Marshall considered only the material things that are capable of promoting welfare of people.
Criticisms of Alfred Marshall definition

a) Marshall considered only material things. But immaterial things, such as the
services of a doctor, a teacher and so on, also promote welfare of the people.
b) Marshall makes a distinction between

(i) those things that are capable of promoting welfare of people, and
(ii) those things that are not capable of promoting welfare of people.
However, anything, such as liquor, that is not capable of promoting welfare but commands a
price, comes under the purview of economics.
c) His definition is based on the concept of welfare. But there is no clear-cut definition
of welfare. The meaning of welfare varies from person to person, country to country
and one period to another.
However, generally, welfare means happiness or comfortable living conditions of an

individual or group of people. The welfare of an individual or nation is dependent not only on
the stock of wealth possessed but also on political, social and cultural activities of the nation.
iii) Welfare Definition

Lionel Robbins published a book “An Essay on the Nature and Significance of Economic
Science” in 1932. According to him, “economics is a science which studies human behaviour
as a relationship between ends and scarce means which have alternative uses”. The major
features of Robbins’ definition are as follows:
a) Ends refer to human wants. Human beings have unlimited number of wants.
b) Resources or means, on the other hand, are limited or scarce in supply.
There is scarcity of a commodity, if its demand is greater than its supply. In other words, the
scarcity of a commodity is to be considered only in relation to its demand.
c) The scarce means are capable of having alternative uses. Hence, anyone will choose
the resource that will satisfy his particular want. Thus, economics, according to
Robbins, is a science of choice.
Criticisms of Robins definition

a) He does not make any distinction between goods conducive to human welfare and
goods that are not conducive to human welfare. In the production of rice and alcoholic
drink, scarce resources are used. But the production of rice promotes human welfare
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while production of alcoholic drinks is not conducive to human welfare. However,

Robbins concludes that economics is neutral between ends.
b) In economics, we not only study the micro economic aspects like how resources are
allocated and how price is determined, but we also study the macro-economic aspect
like how national income is generated. But, Robbins has reduced economics merely to
theory of resource allocation.
c) Robbins definition does not cover the theory of economic growth and development.
iv) Growth Definition

Prof. Paul Samuelson defined economics as “the study of how men and society choose, with
or without the use of money, to employ scarce productive resources which could have
alternative uses, to produce various commodities over time, and distribute them for
consumption, now and in the future among various people and groups of society”.
The major implications of this definition are as follows:

a) He made his definition dynamic by including the element of time in it. Therefore, it
covers the theory of economic growth.
b) Samuelson stressed the problem of scarcity of means in relation to unlimited ends.
Not only the means are scarce, but they could also be put to alternative uses.
c) The definition covers various aspects like production, distribution and consumption.
Of all the definitions discussed above, the ‘growth’ definition stated by Samuelson appears to
be the most satisfactory. However, in modern economics, the subject matter of economics is
divided into main parts, viz., i) Micro Economics and ii) Macro Economics.
Economics is, therefore, rightly considered as the study of allocation of scarce resources (in
relation to unlimited ends) and of determinants of income, output, employment and economic
growth.
Scope of Economics
Scope means province or field of study. In discussing the scope of economics, we have to
indicate whether it is a science or an art and whether it is a positive science or a normative
science. It also covers the subject matter of economics.
i) Economics - A Science and an Art

a) Economics (a science): Science is a systematized body of knowledge that traces the
relationship between cause and effect. Another attribute of science is that its phenomena
should be amenable to measurement. Applying these characteristics, we find that economics
is a branch of knowledge where the various facts relevant to it have been systematically
collected, classified and analyzed. Economics investigates the possibility of deducing
generalizations as regards the economic motives of human beings. The motives of individuals
and business firms can be very easily measured in terms of money. Thus, economics is a
science.
Economics (A Social Science): In order to understand the social aspect of economics, we

should bear in mind that labourers are working on materials drawn from all over the world
and producing commodities to be sold all over the world in order to exchange goods from all
parts of the world to satisfy their wants. There is, thus, a close inter-dependence of millions of
people living in distant lands unknown to one another. In this way, the process of satisfying
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wants is not only an individual process, but also a social process. In economics, one has, thus,
to study social behaviour i.e., behaviour of men in-groups.
b) Economics is also an art. An art is a system of rules for the attainment of a given end. A
science teaches us to know; an art teaches us to do. Applying this definition, we find that
economics offers us practical guidance in the solution of economic problems. Science and art
are complementary to each other and economics is both a science and an art.
ii) Positive and Normative Economics

Economics is both positive and normative science.
a) Positive science: It only describes what it is and normative science prescribes what it
ought to be. Positive science does not indicate what is good or what is bad to the society. It
will simply provide results of economic analysis of a problem.
b) Normative science: It makes distinction between good and bad. It prescribes what should
be done to promote human welfare. A positive statement is based on facts. A normative
statement involves ethical values. For example, “12 per cent of the labour force in India was
unemployed last year” is a positive statement, which could is verified by scientific
measurement. “Twelve per cent unemployment is too high” is normative statement
comparing the fact of 12 per cent unemployment with a standard of what is unreasonable. It
also suggests how it can be rectified. Therefore, economics is a positive as well as normative
science.
iii) Methodology of Economics

Economics as a science adopts two methods for the discovery of its laws and principles, viz;
(a) deductive method, and
(b) inductive method.
a) Deductive method: Here, we descend from the general to particular, i.e., we start from
certain principles that are self-evident or based on strict observations. Then, we carry them
down as a process of pure reasoning to the consequences that they implicitly contain. For
instance, traders earn profit in their businesses is a general statement which is accepted even
without verifying it with the traders. The deductive method is useful in analyzing complex
economic phenomenon where cause and effect are inextricably mixed up. However, the
deductive method is useful only if certain assumptions are valid. (Traders earn profit, if the
demand for the commodity is more).
b) Inductive method: This method mounts up from particular to general, i.e., we begin with
the observation of particular facts and then proceed with the help of reasoning founded on
experience so as to formulate laws and theorems on the basis of observed facts. e.g. data on
consumption of poor, middle and rich income groups of people are collected, classified,
analyzed and important conclusions are drawn out from the results. In deductive method, we
start from certain principles that are either indisputable or based on strict observations and
draw inferences about individual cases. In inductive method, a particular case is examined to
establish a general or universal fact. Both deductive and inductive methods are useful in
economic analysis.
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iv) Subject Matter of Economics

Economics can be studied through;
a) traditional approach, and
(b) modern approach.
a) Traditional Approach: Economics is studied under five major divisions namely

consumption, production, exchange, distribution and public finance.
1. Consumption: The satisfaction of human wants through the use of goods and
services is called consumption.
2. Production: Goods that satisfy human wants are viewed as “bundles of utility”.
Hence production would mean creation of utility or producing (or creating) things for
satisfying human wants. For production, the resources like land, labour, capital and
organization are needed.
3. Exchange: Goods are produced not only for self-consumption, but also for sales.
They are sold to buyers in markets. The process of buying and selling constitutes
exchange.
4. Distribution: The production of any agricultural commodity requires four factors,

viz., land, labour, capital and organization. These four factors of production are to be
rewarded for their services rendered in the process of production. The land owner gets
rent, the labourer earns wage, the capitalist is given with interest and the entrepreneur
is rewarded with profit. The process of determining rent, wage, interest and profit is
called distribution.
5. Public finance: It studies how government gets money and how it spends it.
Thus, in public finance, we study about public revenue and public expenditure.
b) Modern Approach
The study of economics is divided into:
i) Microeconomics, and
ii) Macroeconomics.
i. Microeconomics: analyses the economic behaviour of any particular decision making unit
such as a household or a firm. It also studies the flow of economic resources or factors of
production from households or resource owners to business firms and flow of goods and
services from business firms to households. It studies the behaviour of individual decision
making unit with regard to fixation of price and output and its reactions to the changes in
demand and supply conditions. Hence, microeconomics is also called price theory.
ii. Macroeconomics: studies the behaviour of the economic system as a whole or all the
decision-making units put together. Macroeconomics deals with the behaviour of aggregates
like total employment, gross national product (GNP), national income, general price level,
etc. It is also known as income theory. In addition, macroeconomics ignores the individual’s
preference and welfare. What is true of a part or individual may not be true of the whole and
what is true of the whole may not apply to the parts or individual decision making units. By
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studying about a single small-farmer, generalization cannot be made about all small farmers.
Similarly, the general nature of all small farmers in the state need not be true in case of a
particular small farmer. Hence, the study of both micro economics and macroeconomics is
essential to understand the whole system of economic activities.
b. Basic Economic Concepts of;

i. Want: This is the most unique list of economic satisfaction items desired by man.
While all other economic concepts consider available resources in their decision
making, this does not put any consideration to the available resources in listing its
components. It only lists the desires of man without recourse to his resources. In
essence, its inclusion can be seen to tailor to infinity
ii. Scarcity: This is the condition in which our wants are greater than our limited
resources. Since we are unable to have everything we desire, we must decide on
how we will use our resources in order to attain maximum satisfaction. It can literally
be said to mean ‘there is not enough for everyone’
iii. Opportunity Cost: When a consumer picks an item that is most important to him/her
and pays the price, there is another item that ranks next to the one already selected.
The cost of the next important item is referred to as opportunity cost in economics. It
is also referred to as the cost of the next most important alternative forgone
iv. Scale of Preference: This is a list containing all the items needed by a consumer in
order of importance desired by a person.
v. Choice: Since we are unable to have everything we desire, we must decide on

how we will use our resources. This is achieved by considering the most important
item out of the series of alternatives that we have. The selection of the most important
item is termed choice
vi. Economic Rationality: This is a normative concept that can be applied to a wide
variety of people and situations. Economic rationality would thus require to maximize
their individual interests or utility which could lead them to violate the interests and
rights of others
vii. Economic Assumptions: These are the criteria that are taken for granted as if they do
not matter in the course of analyzing economic situations. The reasons why they are
taken for granted is to see the influence of a particular factor on individual economic
decision making. Good example is when you assume that as price increases quantity
demanded increases. In reality, it is possible that as price increases income of the
consumer might also increase in the same or higher proportion which may have had
a canceling effect
c. Managerial Economics
Managerial Economics is the aspects of micro-economic theory that is most relevant for
decision making within business enterprises like the demand theory, production theory, cost
analysis, pricing practices, business investment decisions, and market structures. This branch
aims at showing how economic analysis can be used in formulating business policies. It deals
with the application of economic theory to business management, so that business decisions
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are taken as a result of economic analysis drawn from concepts such as demand, cost, and
profit. It is the application of economic theory and methodology to business administration
practice. It uses the tools and techniques of economic analysis to analyze and solve business
problems. It also bridges the gap between traditional economics and business administration
decision making as illustrated below.
Managerial Economics and Business Decision Making
Traditional Economic Theory Business Administration

& Methodology Decision Problems
Managerial Economics: Application of Economic Theory

and Methodology to solving business problem
Optimal Solutions to
Business Problems
Scope of Managerial Economics

Micro-economics:
Macro-economics:
Normative-Economics:
Positive Economics:
These various aspects overlap to some extent. Micro and Macro theory are inter-related
because there are micro and macro aspects to specific areas in economics such as economic
development, money and banking, labour economics, public finance, agricultural economics,
and welfare economics. One aspect is not complete without the other aspects. For example,
how much quantity of a product a business firm can sell will depend on the total employment,
income and demand of the entire population in an economy. Also, economic systems are
studied in positive. Descriptive economics must be understood before meaningful normative
rules can be formulated. Although both micro and macro economics are important in
managerial economics, the micro theory of the firm is especially significant.
It may be said that the theory of the firm is the single most important element in managerial
economics. However, because the individual firm is very much influenced by the general
economy, which is the domain of macro economics, managerial economics does involve
macro theory. The emphasis of managerial economics is certainly on normative theory i.e.
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establishing decision rules that will help business firms attain their goals. But if firms are to
establish valid decision rules, they must thoroughly understand their environment, i.e.
descriptive economics cannot be ignored.
Uses and Applications of Managerial Economic

i. Business economics/Managerial Economic is a total course, wherein certain economic
theories, methods and techniques of analysis are covered in preparation for their later
use in the functional areas.
ii. It also serves as an integrating course, combining the various functional areas and
showing how they interact with one another as the firm attempts to achieve its goals.
iii. Another aspect of Managerial Economics is that it bridges the gap between the firm
and society. Managerial Economic can help to clarify the vital roles business firms
play in our society and to point out ways of improving their operations for its benefit.
d. The Economic System and Basic Economic Problems of Society

Economics is mainly concerned with the achievements and uses of material requirements to
satisfy human wants. However, human wants are unlimited and productive resources are
limited. Therefore, goods and services which satisfy human wants are scare. Because of the
scarcity and limitedness of resources and limited availability of goods and services we have
basic economic problems.
The basic economic problems of an economy can be given as follows:

i. What to produce?
ii. How to produce?
iii. For whom to produce?
iv. Efficiency of production.
i) What to Produce?
As the resources are limited and wants are unlimited the problem of what to produce implies
that a society has to decide which goods and in what quantities they are to be produced. With
the help of Production Possibility Curve (PPC), the problem of what to produce and how to
produce can be addressed. PPC is also known as transformation curve as moving from one
point to another there is transformation of one good into another by shifting of resources used
for their production.
ii) How to produce?

This is the problem of choice of technique. There are mainly two types of technology
available for the production of a good. First is the labour intensive technology, which uses
more labour than machines and second is the capital intensive technology, in which there is
more use of capital or machines as compared to the labour. Further it means with what
combination of resources a society decides to produce goods. Usually, there are various
alternatives; there are various techniques of production of a commodity. In order to explain
these problems we take into account two factors of production, they are labour and capital.
An economy having abundance of labour would produce labour intensive production system,
on the other hand economy having huge supply of capital intensive production. For example,
India is a Labour Intensive Country and Japan is capital intensive country.
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iii) For whom to produce?

This is the problem of distribution of goods between different income groups of the society.
How many resources are used for the rich and the middle class and what is left for the poor?
This tells us about the relative importance the economy gives to the needs of the rich and
poor. It also means the choice between present and the future needs. It implies how the
national product is distributed among the various sections of societies, there are limited
resources an economist has to decide who should get what and how much. This is to say how
the national income is distributed among various segments of the society. An economy has to
check whether this distribution is proper and the weaker section of the society is not deprived
of the basic necessities of life.
iv) Efficiency of Production

Another important problem faced by an economy is to examine whether the production
process is carried out in the most efficient manner. The problem of efficiency is explained
with the help of the figure1.3. If the economy is not using its resources optimally then they
are either underutilized or unemployed. This is called inefficient use of the given resources,
because the output of the economy remains below the production possibility curve as shown
by point U.
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CHAPTER TWO
2 THEORY OF CONSUMER BEHAVIOUR
Concept of utility
Utility is defined as the power of a commodity or service that a consumer uses satisfies the
purposes for which such good or service was consumed. Utility is thus the satisfaction which
is derived by the consumer for consuming the goods in question. Two different approaches
are involved in economics when studying utility. These are; cardinal approach, and ordinal
approach
a. The Cardinalists Approach (Utility Concept)

This approach is introduced through the identification of its assumptions.
Assumptions of Cardinal Utility Analysis

The main assumptions or premises on which the cardinal utility analysis rests are as under.
(i) Rationality: The consumer is rational. He seeks to maximize his satisfaction from the
limited income which is at his disposal.
(ii) Utility is cardinally measurable: The utility can be measured in cardinal numbers
such as 1, 3, 10, 15, etc. The utility is expressed in imaginary cardinal numbers tells
us a great deal about the preference of the consumer for a good.
(iii) Marginal utility of money remains constant: Another important premise of cardinal
utility is that money spent on the purchase of a good or service should remain
constant.
(iv) Diminishing marginal utility: It is also assumed that the marginal utility obtained
from the consumption of a good diminishes continuously as its consumption is
increased.
Law of Diminishing Marginal Utility

This law can be explained by taking a very simple example. Suppose, a man is very thirsty
and he goes to the market and buys one bottle of water. The bottle of water gives him
immense pleasure or we say the first bottle of water has great utility for him. If he takes
second bottle of water after the first, the utility will be less than that of the first one. It is
because the edge of his thirst has been blunted to a great extent. If he drinks third bottle of
water, the utility of the third bottle will be less than that of second and so on.
The utility goes on diminishing with the consumption of every successive bottle of water till
it drops down to zero. This is the point of satiety. It is the position of consumer’s equilibrium
or maximum satisfaction. If the consumer is forced further to take a bottle of water, it leads to
disutility causing total utility to decline. The marginal utility will become negative. A rational
consumer will stop taking water at the point at which marginal utility becomes negative even
if the good is free. In short, the more we have of a thing, ceteris paribus, the less we want still
more of that, or to be more precise.
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In given span of time, the more of a specific product a consumer obtains, the less anxious he
is to get more units of that product or we can say that as more units of a good are consumed,
additional units will provide less additional satisfaction than previous units.
(v) Independent utilities: According to the Cardinalists school, the utility which is
derived from the consumption of a good is a function of the quantity of that good
alone. It does not depend at all upon the quantity consumed of other goods. The
goods, we can say, possess independent utilities and are additive. We are invariably
saying that utility derivable from consuming rice for example is a function of how
many plates of rice a consumer eats and not a function of rice and spaghetti eaten. The
consumption of spaghetti does not add value to his utility from rice consumption
(vi) Introspection method: The Cardinalists School assumes that the behavior of
marginal utility in the mind of another person can be judged with the help of self
observation. For example, I know that as I purchase more and more of a good, the less
the utility that I derive from the additional units of it. By applying the same principle,
I can read other people’s mind and say with confidence that marginal utility of a good
diminishes as they have more units of it.
b. The Ordinalists Approach (Indifference Curve Concept)

An indifference curve is the locus of points of particular combinations or bundles of goods
which yield the same utility (level of satisfaction) to the consumer so that he remains the
same as to the particular combination he consumes. This simply means that if a consumer can
measure his satisfaction from consuming 20 units of X and 20 units of Y and that satisfaction
is say 50 utils. Then, the indifference curve states that a reduction in some quantity of X when
complemented with increase in the quantity of Y can make the consumer to maintain the
same level of 50 utils (satisfaction)
Assumptions of Ordinalists Approach
i. It is assumed that the commodities Y & X can substitute one another to a certain
extent but are not perfect substitutes.
Readers are to be careful as to the implied statement here that ‘commodities X and Y can
complement each other to a certain extent’. Let us suppose that a consumer believes that four
slices of yam with two fried eggs will give him a level of satisfaction as breakfast. The same
consumer may believe that one fried egg with five slices of yam will make him maintaining
the same satisfaction. The reduction in the number of eggs may be unavailability to purchase
or other reasons. However, it will be unimagined that eating only eggs or only yam in the
absence of the other will make him maintain the same satisfaction.
ii. The consumer is assumed to be rational i.e. he aims at the maximization of his utility,
given his income and market prices. Assuming he has full relevant information.
iii. Utility is assumed ordinal i.e. consumers can rank their preferences (order the various
baskets of goods) according to the satisfaction of each basket. They need not know
precisely the amount of satisfaction. It is not necessary to assume that utility is
cardinally measured only ordinal measurement is required.
iv. Diminishing marginal rate of substitution i.e. the indifference curve theory is based on
the axiom of diminishing MRS preferences is ranked in terms of indifference curve
which are assumed to be convex to the origin.
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v. The total utility of the consumer depends on the quantities of the commodities
consumed U = f (q, q2, ….. qx, qy ….. qn)
vi. Consistency and transibility of choice i.e. if AB, then B cannot beA.
And if A is preferred to B and B preferred to C, then bundle A is preferred to C.
i.e. if A  B, & B  C, then A  C.
Properties of an Indifference Curve
i. An indifference curve has a negative slop denoting that as the quantity of one
commodity (Y) decreases; the quantity of the other (X) must increase, if the consumer
is to stay on the same level of satisfaction.
ii. The further away from the origin an indifference curve is, the higher the level of
utility it denotes, bundles of goods on a higher indifference curve are preferred by the
rational consumer.
iii. Indifference curves do not intersect. If they did, the point of their intersection would
imply two different levels of satisfaction, which is impossible.
We cannot have indifference curve IC1 and IC2 as indicated in the following diagram. The
reason for the impossibility is that the curve below had its two curves intersecting at point C.
iv. Indifference curves are convex to the origin i.e. the marginal rate of substitution
(MRS) of the commodities is diminishing. It becomes increasingly difficult to
substitute x for y as we move along the indifference curve.
The convexity can be further explained by considering the labeling in the curve that follows.
At point B along the curve, there is a degree of substituting some units of A for B. also at
point C, a consumer can substitute some units of A for B or some units of B for A. However,
this substitution fades away as we move up to points A and D along the indifference curve
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Appraisal of the Indifference Curve Approach

The indifference curve analysis has been a major advance in the field of consumers demand.
The assumptions are less stringent than for the cardinal utility approach. Utility need not be
measurable, only ordinality of preferences is required. Consumer is only required to be able
to rank the various baskets of goods according to the satisfaction that each bundle gives him.
The approach has established a better criterion for the classification of goods into substitutes
and complements.
Limitations
Assumption of the existence and the convexity of the indifference curve are not established. It
is questionable whether the consumer is able to order his preferences as precisely as
rationality and the theory implies. Cost preference changes even if ordering is possible. It has
retained most of the weakness of the cardinalist school with the strong assumption of
rationality and the concept of the MU implicit in the definition of the MRS.
It does not analyze the effects of advertising, of past behaviours (habit persistence), of stocks,
of the interdependence of the preferences of the consumers, which lead to behaviour that
would be considered as irrational and hence ruled out by the theory. Speculative demand and
random behaviour are ruled out yet these factors are very important for the pricing and output
decisions of the firm.
Applications of Indifference Curve Analysis

i. Indifference curve analysis can be used to evaluate alternative government policies
e.g. Government considering the adoption of either a food subsidization policy for
pensioners or granting them a supplementary income. The goal of the government is
to make it possible for the pensioner to move to the higher level of welfare
(satisfaction) i.e. moving to a higher indifference-curve.
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ii. Indifference curve analysis may be used to explain why exchanges of commodities
among individuals (or groups, regions etc.) take place. Under certain conditions,
exchanges of commodities lead to an increase in the welfare of at least one individual
without any reduction in the welfare of the other(s), so that the overall welfare which
can be enjoyed from a given bundle of commodity is increased. Indifference curve
analysis can be used to establish whether over a period of time during which money
income and prices have been changing, the consumer is better or worse off i.e.
assuming consumer spends all his money income in a time period.
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CHAPTER THREE
3. PRODUCTION AND COST THEORIES
a. Theory of Production
Production theory provides explanation or useful insights in analyzing questions that are
critically important to the firm. Examples of such questions are, given;
i. demand for its product, how does a firm determine its optimal level of output?
ii. several alternative production methods, which one should the firm choose?
iii. increase in productive capacity, will the cost per unit be higher/lower with expansion?
A firm is the key economic/production unit which determines what, the quantity, how, and
when to produce a given commodity. On the other hand, the individual consumer attempts to
maximize his satisfaction, given his income, and the commodity prices. The firm attempts to
maximize profit given the cost outlay by the way in which it secures and combines the
resource inputs/factors of production.
Production is the transformation of inputs into output. Economically, it is concerned with the
whole process of making goods and services available to consumers. This technical
relationship between input and output is economically referred to as the production function.
It specifies the maximum possible output that can be produced from a given amount of inputs
or, alternatively; the minimum quantity of inputs necessary to produce a given level of output.
Inputs can, of course be used inefficiently, but the production function concept assumes that
firms operate efficiently. Production functions are determined by the technology and
equipment available to the firm. Any improvement in technology, such as better equipment or
a training program that enhances workers productivity, results in a new production function.
The basic properties of production function can be illustrated by examining a simple two-
input, one output system. Assume that a particular production process can use various
quantities of two inputs X and Y to produce the product Q.
X and Y may represent resources such as labour and capital. The product Q could be
physical goods or services. The production function for such a system can be written:
Q = f (X,Y) - - - - -- - - - - - - - - - - - - - - - - - - - - - (1)
This equation could be specified as Q = X + Y, where X represents labour, Y represents land
and Q is tonnes of maize. In this case, two tonnes of maize can be produced by employing 1
unit of labour and 1 unit of land.
Two tons by using 1X and 1Y
Four tons by combining 2X + 2Y
The properties of production functions can be graphically examined by means of isoquants.

‘Iso’ means equal, ‘Quant’ means quantity. The term denotes a curve that represents all the
different combinations of inputs which when combined efficiently produce a specified
quantity of output. Efficiency here refers to technical efficiency because production theory
assumes that only the most efficient techniques are used in converting resources inputs into
products.
Substitution of Input Factor

The shapes of the isoquants reveal a great deal about the substitutability of the input factors
i.e. ability to replace/substitute one input for another in the production process.
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(a) In some production system, input substitution or replacement is readily accomplished

e.g. in the production of electricity fuels (gas, oil) used to power generators often
represent readily substitutable inputs and so the isoquants are straight inverse lines.
Gas Perfect Substitution

Q3
Q2
Q1 Oil
(b) At the other extreme of input substitutability lie production systems in which inputs
are perfect complements for each other. In these situation, exact amount of each input
are required to produce a given quantity of output. For example, exactly two wheels
and one frame are required to produce a bicycle, and in no way can wheels be
substituted for frames or vice versa and so the isoquants has a right-angle shape.
Frames inputs are perfect complements
3 Q3 = 3 bicycles
2 Q2 = 2 bicycles
1 Q1 = 1 bicycle
O
2 4 6 Wheels
(c) The C shaped isoquants represents cases where inputs can be substituted within limits
i.e. are substitutable but not perfect substitutes e.g. a dress can be made with a
relatively small amount of labour (A1) and a large amount of cloth (B1). The same
dress can be made with less cloth (B2) and more labour (A2) i.e. more carefulness and
reduce wastage. Finally, the dress can be made with even less cloth (B3) but the
worker must be extra careful that labour input requirement increases to (A3). Note
that while a relatively small addition to (A) from (A1) to (A2) allows the input of
cloth to be reduced from (B1) to B2, a very large increase in A from (A2) to (A3) is
required to obtain a small reduction in B from (B2) to (B3).
The substitutability of A for B diminishes as we move from point A to B in the figure

below
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Marginal Rate of Substitution

The slope of the isoquant provides the key to the substitutability of input factors. The slope is
the change in one input (cloth) divided by the change in the other input (labour). This
relationship known as the MRS of factor inputs is the amount of one factor that must be
substituted for one unit of another input factor to maintain a constant level of output.
MRS =  A = da = slope of an isoquant
B db
MRS usually diminishes as the amount of substitution increases. e.g., as more and more
labour (A) is substituted for cloth, the increment of labour necessary to reduce cloth (B)
increases. Finally at the extremes, isoquants may even become positively sloped indicating
that the range over which input factors can be substituted for each other is limited while the
level of production is held constant.
Returns to scale and returns to factor

In studying production functions, two important relations between inputs and outputs are of
interest in managerial decision making. This is the relation between output and the variation
in all input taken together; it is known as the returns to scale characteristic of production
system.
Returns to scale is the output effect of a proportional increase in all inputs. It plays an
important role in manager decisions. They affect the optimal scale or size of a firm and
production facilities. They also affect the nature of competition in an industry and thus are
important in determining profitability of investment in a particular economic sector. Returns
to scale are measured by comparing the percentage change in quantity with the percentage
change in all inputs. It has to do with how a proportionate increase in all inputs will affect
total product. There are three possible scenarios under returns to scale
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i. Constant returns to Scale: this exists when a given percentage increases in all inputs lead to
that same percentage increase in output e.g. when the use 50 units of A, and 50 units of B
generated 150 units of output (C) at the first instance and at another instance when doubling
the use of resources to a new level of; 100 units of input A, and 100 units of input B lead to
the production of 300 units of output, then we have a constant return to scale.
ii. Increasing returns to scale: this exists if the proportional increase in output is larger than the
underlying proportional increase in input. As an illustration consider the situation indicated
under constant returns to scale. If instead of expecting 300, a more than 300 such as 301, 302,
etc was realized when it was certain that all inputs have been exactly doubled, then we have
an increasing returns to scale
iii. Decreasing returns to scale: this is a situation that arises when output increase at a rate
less than the proportionate increase in inputs. For the same given illustration under
constant return to scale, if after doubling all the inputs the out was less than double such as
299 and any other number below, then we refer to the situation as deceasing returns to scale
The second important relation in any production system is returns to a factor. It denotes the
relationship between the quantity of an individual input employed and the level of output produced.
Factor productivity is the key to determine the optimal combination of inputs that should be used to
manufacture a given product. Factor productivity analysis provides the basis for efficient resource
employment in all production system.
The concept of factor productivity or returns to a factor is important in the process of determining the
optimal input combinations for any production system. Because the process of optimization entails
an analysis of the relationship between the total and marginal values of the function, we shall look at
the concept of Total, Average and marginal products for the resources employed in production
system.
Total product: the complete output from a production system. TP increases as inputs used increases
ceteris paribus.
Average product: Total product divided by the number of units of input employed.
APX = TPx
X
Marginal product: Change in output resulting from a one unit change in a single (variable) input,
while the other inputs remain unchanged.
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Concepts of Total, Marginal, and Average productivities

Input quantity (X) TPx of output (Q) MPx =∆TPx AP = Q
∆X X
1 15 15 15
2 31 16 15.5
3 48 17 16
4 59 11 14.8
5 68 9 13.6
6 72 4 12
7 72 0 10.3
8 71 -1 9
9 69 -2 7.8
10 67 -3 6.7
The law of diminishing returns to a factor is demonstrated by the products curves and its states that
as the quantity of a variable input increases with the quantities of all other factor being held constant,
the resulting rate of increase in output eventually diminishes. TP increases first at an increasing rate
but later at a decreasing rate until eventually it starts to decline.
A marginal relationship is defined as the change in the dependent variable of a function associated
with a unitary change in one of the independent variables. In the total production function, MP is the
change in TP associated with a one unit change in a variable input. i.e. marginal represents the
change in total. For a function to be at a maximum, its marginal value (slope) must be zero.
When MP is positive, TP increases, though at a decreasing rate. At Q=100, MP=0 & TP is

maximum. Beyond Q=100, MP is negative and total profit is decreasing. Another e.g. of the
importance of the marginal concept in economic decision analysis is provided by the
important fact that MR =MC at the point of profit maximization.
T = TR –TC
M = MR –MC
and since maximization of any firm requires the Mд of the firm to be set equal to zero, Profit
is max when M = MR – MC =0 or when MR = MC
In determining the optimal activity level for a firm, the marginal relations tells us that as long
as the increase in Revenue associated with expanding output exceeds the increase in costs,
continued expansion will be profitable. The Optimal Output level is determined when MR =
MC, M = 0, and TP is maximized
Factors of Production
These are the agents of production referred to as input or resources that goes into the
production of goods and services designed to satisfy human wants.
(a) Variable Factors: supply can be altered in the short-run (labour, capital, entrepreneur).
(b) Fixed Factors: supply cannot be changed in the short-run.
(c) Specific Factor: Specifically designed for a particular purpose e.g. machinery.
(d) Non-Specific Factors: Can be adapted to perform any purpose.
(e) Human Factors: Human beings e.g. labour, entrepreneur.
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Factors Classification:
(1) Land: means all materials and forces supplied by nature. They are gifts of nature.
Characteristics of Land
- Free gift of nature (no cost of production)
- Immovable (used where found)
- Supply is fixed in the short run (its supply cannot be increased).
- It is heterogeneous (of varying characteristics).
- Subject to the law of diminishing returns i.e. productivity decline with use.
Law of Diminishing Returns:

States that if a variable factor is combined with a fixed factor in a production process,
successive addition of the variable factor to the fixed factor will initially cause total output to
increase at an increasing rate and later total output will rise at a decreasing rate until TP
eventually starts to decline.
Diminishing returns to constant factor

Unit of land Unit of labour TP AP MP
(fixed factor) (variable factor)
1 1 10 10 10
1 2 22 11 12
1 3 37 12.3 15
1 4 52 13 15
1 5 61 12.2 9
1 6 66 11 5
1 7 66 9.4 0
1 8 65 8.1 -1
Explanation
Observe that from start of the (a) diagram designated as total product curve, output rise
sharply until it reaches point B. This section is called phase I. It is a stage where addition to
output as result of increasing variable factor by one unit leads to increase that is more what
increase was recorded from the previously added unit of the variable factor. After this phase,
a second phase is classified as phase II. This second phase also indicates rising total output
but the rate at which the increase is being felt is at a reduced rate compared to the situation in
phase I. phase II continues up till point D. Anything beyond point D as shown in diagram (a)
will result in a crash (reduction) in total output.
With reference to the second diagram, the relationship between marginal and average as they
relate to total output was explained. At any time when total output was increasing up till point
B as depicted in diagram (a), marginal product was increasing at an increasing rate. Note the
significance of the phrase ‘increasing at an increasing rate’. It means that when one unit of
variable factor of production contributes say 15 units to output at first; when again another
variable factor of production is added the second quantity of variable factor independently
contribute say 17 (this implies that the first factor and the second factor both produced 33). If
again a third variable factor was added and the third variable factor led to say 22 units of
output (jointly the three factors produced 15 + 17 + 33 = 75). This is what is meant by
increasing at an increasing rate. All through this point average product was increasing. For
example, when 15 were produced, its average was also 15. When 32 were produced by the
combination of two factors, their average was 16, and lastly based on this explanation when
75 were produced by three factors, their average rose 25.
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Beyond point B in diagram (a) which coincided with output QB and output QB’ in diagram in
diagram (b), a clear observation can be noticed. It was observed that marginal curve was
decreasing. This means that the addition to output as a result of increasing variable input was
decreasing due to reasons such as decreasing returns to scale. The effect of this on average
product is a decrease. At point D on curve (a), marginal product reaches 0, beyond this point
marginal product becomes negative (a situation designated as phase III). Readers should be
careful not to assume that negative quantity can be produced, rather inefficiency has set in to
the extent that overall output is on the decline. We only explain marginal as negative since we
are evaluating the effect of marginal input on total output. All through the diagrams, it must
be noted that total product can never be negative, instead it will continue to approach zero but
can never be zero. Likewise, average product can never be zero but its value will keep falling
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2. Labour
All human efforts physical or mental exerted to produce a good or service for which payment
is made. It refers to the services of human beings.
Characteristics
- As a human factor, labour is unique, can make mistake and are unpredictable.
- Geographically or occupationally mobile.
- Supply is fairly inelastic in the short-run since it takes some time to acquire expertise.
- It is perishable; cannot be stored for future use.
- It is heterogeneous; many species (skilled, unskilled).
- Producers and at the same time consumers.
Supply of labour: is the total number man-hours made available for production at a point in
time. It is influenced by
(i) the total population, and
(ii) the proportion of the population that participate in production i.e. working class.
Efficiency of Labour: It is the ability of labour to produce the maximum output. It can be
influenced by:
(i) Strength and capability of the worker
(ii) Method and amount of remuneration;
(iii) Working environment;
(iv) Education and facilities for training;
(v) Adequate employer-employee relationship;
(vi) Job security and career prospects,
(vii) Adequate food, shelter, and clothing;
(viii) Efficiency and adequacy of other factors of production;
(ix) Psychological factors e.g. personal freedom and initiative.
Division of Labour/Specialization
Division of labour is the specialization of labour into jobs; production process is divided into
various activities / stages where workers perform different types of jobs. There is the need
for workers cooperation for a successful production process since each worker will produce
only a part of the product.
Merits and demerits of division of labour

Merits Demerits
Enhances specialization in jobs of workers Monotony of work

preference leading to Improves workers’ skills
Saves time. Risk of unemployment with narrow
specialization.
Increased output at reduced cost. Loss of craftsmanship – no pride of
ownership – mere tender of machines.
Enhances greater use of machinery.
Limitations of division of labour
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i. Size of the market

ii. There are works that cannot be divided into jobs or stages e.g. driving.
iii. Mobility of Labour: It is the movement of labour from one occupation to another
(occupational mobility) or from one industry to another (Geographical mobility or
from one location to another (Geographical mobility).
Factors Affecting Mobility of Labour

i. Age
ii. Sex
iii. Marital Status
iv. Trade Union regulations e.g. untrained cannot be licensed.
Demerits of Immobility
Creates zones of surplus and zone of scarcity of labour
(3) Capital
It is any form of wealth, set aside for the creation / production of further wealth.
Classifications of capital
Fixed Capital: does not change form in the process of production e.g. buildings, tools.
Usually used for a long time.
Circulating Capital: are used up and transformed into finished goods in the process of
production e.g. raw materials. Its supply must be regular.
Social Capital: enhances production efficiency. They are very expensive and take a long
time to build up, therefore provided by the government, e.g. infrastructural facilities like
schools, roads.
Finance/Money Capital: It is also circulating and used up but very important in that:
i. It’s required to meet all costs.
ii. Needed to buy raw materials etc.
iii. It’s either in form of cash or stock therefore has its own price and market.
iv. It’s raised in form of loans and stocks are sold on the capital market.
v. Money, stock and shares are claims to wealth though they are worthless on their own
i.e. have a derived demand.
Characteristics of Capital
i. Created by human beings.
ii. Heterogeneous – have many species – fixed, floating, etc.
iii. Supply is fair inelastic in the short run.
iv. Geographically and occupationally mobile but occupational mobility has limitations if
specific.
(4) Entrepreneur
This describes the managerial ability of the owner of the firm who uses his initiatives, takes
risks, and manages the firm skillfully. He decides what to produce, how to produce, for
whom etc. He brings together, organizes, and coordinates other factors of production in the
required proportion to produce. His reward is profit.
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b. Theory of Cost
It is the branch of economic study concerned with the study of the cost of production
expressed in monetary terms as opposed to the production theory which is concerned with the
input-output relations in quantitative terms. Cost of production is the basic factor that
influences the willingness and the ability of firms to supply a product in the market since the
firm’s objective is to maximize profit. Therefore, the main aim is to keep costs as low as
possible. Cost refers to all items of expenditure incurred by a producer for producing a given
volume of output. Cost consideration is important for the following reasons:
i. It enables an enterprise to make the least cost decision that maximize his profit since
Profit = R =C.
ii. It is a measure of efficiency. If costs are rising, it is a signal of inefficiency in the
management of resources.
iii. It is useful in locating weak points in production management
iv. It is important for pricing purposes
v. It is useful in the determination of optimum level of output
vi. It is useful in assessing profitability of production
vii. It is useful in determining in advance cost of production
You may be able to price others out and still make profit with good cost considerations.
Cost Concepts
Types of Costs/Elements of Costs:
There are many types of costs. To the Accountants, and the Economists: Some of them are:
i. Prime Cost: Prime costs consists of direct labour cost (wages and salaries), direct
material costs and direct expenditure costs
ii. Indirect production costs include costs of factory over heads e.g. central heating/air-
condition system.
All other costs are also considered by the accountants e.g. selling costs, distribution costs,
administrative costs, research and development costs, financial costs (interest on loan).
All those are considered when calculating the total costs of production and it is important in
the determination of selling price which can be fixed only when you know what it costs you
to produce a product.
To Economists Cost means

i. Opportunity Cost: Which is the alternative you had to forgo to be able to produce a
commodity. It is the cost society incurred when its resources are used to produce a
given commodity rather than another one.
ii. Explicit Costs: Are firm’s money outlay to meet direct costs of production e.g.
payment for raw materials, fuel, transportation, wages and salaries
iii. Implicit Costs: are costs not traceable to anything. They are national costs imputed
to make sure that profits are not overstated. Not an actual cash outlay. This implies
that there is no cash movement you just put it down in your books of account e.g.
depreciation, provision for bad debt etc.
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iv. Business Costs: Include all payments and contractual obligation made by the
business entity together all book costs.
v. Full Cost: Business costs plus all alternative costs.
Incremental Vs Sunk Costs:

i. Sunk costs are costs already incurred and are not affected by changes in activity level
or nature.
ii. Incremental costs are the added costs of a change as you add a new product, change
your distribution channel etc.
iii. Historical Cost: Costs of assets acquired in the past e.g. Cost of plant.
iv. Replacement Cost: How much it costs to replace an asset.
v. Escapable Costs: are costs that can be avoided e.g. as a result of contractions in the
firms activities.
vi. Unavoidable Costs: are incremental costs of new projects which involve added
costs.
vii. Fixed Cost: are costs incurred regardless of the level of output e.g. rents. But
variable costs vary directly with output level. It increases as output level increases
and vice-versa though not necessarily in the same proportion e.g. raw material.
Cost
O output level
TC = FC + VC
Total cost is a function of quantity produced
TC = F(Q)
TC= TFC+TVC
Figure zzz: Note that there is an equal distance between TC and TVC. The space designate
the TFC relation. By mathematical manipulation, it should be observed that the addition of
TVC and TFC lead to TC
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ATC = TC or AFC + AVC

Q
FC = TC - VC
Figure xxx: Note the continuously declining AFC. This is because the fixed cost is spread
over increasing number of output as output increases. Also observe that the other three curves
portrayed a U shaped curve. From the left side of the cost axis where they all took off, it was
observed that all the three curves were declining (this was a stage of increasing returns to
scale to the firm) until they all reached a minimum. Beyond the minimum point, decreasing
returns to scale set in. as decreasing returns to scale set in (it becomes less cost effective to
the firm, thus the upward shift in these curves). One other technical thing that readers should
note is that when the curves shift upward after reaching minimum, the variable responsible
for the increasing returns to scale when they were all falling was MC, this same variable will
take lead in upward direction. In taking the lead direction, it will cut all other curves at the
minimum point of the U shapes.
VC = TC - FC
AFC = ATC – AVC
Figure ccc: Average cost is asymptotically approaching zero but can never be zero. This is
because the same cost is spread over increasing units of output as more of the product is
produced.
MC = extra cost incurred by producing an extra unit of a product.

MC = ∆TC
∆Q
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Cost-output relations
Output TFC TVC TC (2+3) AFC AVC AC MC= ∆TC
(Q) (2/Q) (3/Q) (4/Q) ∆Q
0 140 - 140 140 7.0 14.0 -
10 140 70 210 14.0 7.0 21.0 7
20 140 110 250 7.0 5.5 12.5 4
30 140 180 320 24.7 6.0 10.7 7
40 140 280 420 3.5 7.0 10.5 10
50 140 450 490 2.8 9.0 11.8 17
60 140 720 860 2.3 12.0 14.3 27
70 140 1120 1260 2.0 16.0 18.0 40
80 140 1680 1820 1.8 21.0 22.8 56
Above information can be represented graphically. See above both AC and MC curves are
U-shaped reflecting the law of variable proportions but they intersect at a point where AC is
minimum.
Before the optimum output, AC is above the MC and it pays to increase output but beyond
that point, AC is above MC and the cost of producing one more unit is too high and it pays to
reduce output level.
In the long run, all factors can be varied and therefore costs are variable hence it is possible
for firms to vary its sizes as it wishes. Unit cost of production decreases as plant size
increases due to economies of scale up to a certain point / size i.e. the optimum size where
further increases in plant size brings managerial inefficiencies and diseconomies of scale and
therefore LAC turns upwards.
c. Theory of Reward
Theory X & Theory Y'
Theory X and theory Y are part of motivational theories. Both the theories, which are very
different from each other, are used by managers to motivate their employees. Theory X gives
importance to supervision, while theory Y stresses on rewards and recognition.
Theory X and theory Y follow different methodologies of keeping people motivated. Theory
X follows an authoritarian approach to motivate people. One of the key assumptions in this
approach is that the average employee doesn't like work and will do anything to avoid it. The
other assumption under theory X is that the employees need to be threatened or forced to
work towards the organizational goals. They will avoid responsibility and the managers have
to supervise them at every step. In an organisation where theory X is followed, the
management too follows an authoritarian style. There is little delegation of authority from the
management. On the other hand, companies who follow theory Y have a more decentralized
approach, which means that the authority is distributed among employees. This keeps them
motivated. There are some key assumptions under theory Y. One of them is that employees
take responsibility of their actions and work towards achieving the goals of the organization
without much supervision. The workers are more participative and try to solve problems on
their own without relying on supervisors for guidance. This type of management style is more
30 | P a g e
common than theory X. In this type of management style, even a small employee can
participate in the decision-making process. Theory X works on the idea of punishing people
to keep the work going, while under theory Y, promotions, rewards, and recognition play an
important part. This keeps employees motivated to work hard towards achieving goals of the
organisation.
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CHAPTER FOUR
4. PRICE SYSTEM
a. The Theory of Demand
Demand is defined as the quantity of a particular commodity that consumers are
willing and able to purchase during a specified period and under a given set of
conditions. A thorough analysis of this economic definition reveals four key words
that are important in this definition. These words/phrases are indicated in italics and
we attempt to put the four in clear terms.
Someone might be the richest in a community, this person recently migrated from the
south east (Imo state) to Ibadan (South west) and does not take a local delicacy
(Amala + Ewedu & Gbegiri). Much as this rich person might be hungry and needed
food to quench hunger, he becomes impaired (unwilling) in ordering this local
delicacy. He is not willing because he does not take that type of meal. As wrongly
concepted by some students of economics, money is not just the only constraint to
demand.
Next, as italicized above is that the consumer must be able to place demand.
This can be taken to mean that the consumer must have money to place the order for
the product in question and must be legally qualified to purchase in case of products
with age related constraint such as cigarette.
Our third important consideration is specified period. The essence of this is that
demand is always a time frame variable. Thus we can always hear that 300 units
Toyota highlander were purchased between January and March, 2018. It may also
be that 750 copies of principles of economics textbook were purchased in April,
2018. Any demand stated without time frame is not complete demand
information.
Lastly is the phrase ‘a given set of conditions’. The most fundamental condition is
that the product in question must have a price attached to it. Consumers do not go for
a product without knowing what (price) the product exchanges for. Other important
components of a given set of condition are prices of other related goods, expectations
of price changes consumers’ incomes, consumers taste and preferences, advertising
expenditures, whether condition, size of the population, and Government policy.
The Demand Function

Expressed in general functional form, the demand function may be stated as follows:
Quantity Demanded = Qx = f (Price of product x (Px), Prices of other related goods (Po),
Expectation of price changes (E), consumers income (Y), taste (T), technological
Advancement (Tech), Advertisement (Ad) weather (W), population size (Pop), Government
Policy (G).
Qx = f(Px/ Po. E, Y, T, Tech Ad, W. Pop, G.)…………………………………..4.1
This is to say that Q is a linear function and dependent on all the listed factors.
A general functional equation would be:

Qx = a - bPx + cPo + dE + eY+ fT + gTech + hAd + iW + jPop + kG
Where a = autonomous demand (demand when all the listed factors collapse to zero)
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b, c, ….. k = coefficients of parameters (their signs +/- depend on relationship with demand)
From equation 4.1, ten factors were listed as influencing demand in this illustration. Observe
that after the first factor which is the price of the product being considered, a forward slash
sign was separating the other nine variables. The economic interpretation is that only price of
the commodity in question is responsible for change in quantity demanded while all other
identified factors jointly responsible for change in demand
Differences between changes in quantity demanded and change demand

s/no Changes in quantity demand Change in demand
(The demand curve) (Shifts in demand curve)
i The change is along the same The change is giving rise to another demand
demand curve curve (either up or down)
ii Price of the product is responsible Other factors apart from price of the product are
for these changes. responsible for these changes
The Law of Demand

The law of demand states that the higher the price of a commodity; all other things being
equal, the lower the quantity demanded and vice versa. This law invariably states that there is
an inverse relationship between price and quantity demanded. It slops downward from left to
right indicating that the higher the price, the lower the quantity demanded and vice versa all
thing being equal. (Figures 1 & 2).
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Exceptions to the Law of Demand

The normal demand curve is downward sloping from left to right i.e. less of a commodity is
demanded as its price rises and vice versa all things being equal. But all things are not always
equal and there are exceptions to the law and it is not always the case that anytime there is an
increase in price, quantity demanded will reduce.
i Anticipatory Purchases:
People make anticipatory purchases when they speculate about future changes in price. When
the speculation is that prices are likely to increase in the near future, an increase in price will
represent a signal for future price increase so that the people will buy more now despite the
price increase and vice versa.
ii. The Case of an Inferior good

Inferior goods in economics mean good whose consumption falls as people’s red income
increases. Consumption of an inferior good rises when the real income of the consumer falls.
As prices of inferior goods fall, the real income of the consumer increases, he is richer and
therefore reduces his purchase of inferior goods since he can now afford more superior goods
and vice versa.
iii. Articles of Ostentation/Veblen effect

The concept was introduced by Professor Veblen for Cases of conspicuous consumption. The
desire to look conspicuous in the society makes some people prefer to buy expensive thing.
They buy only when commodities demand very high prices e.g. trinkets.
iv. Bandwagon effects

Here, demand increases because others are buying the commodity. People purchase in order
to confirm with people they wish to associate with. To appear fashionable, even in the face of
high prices.
v. Snob effect
This applies to the extent to which the demand for a commodity is decreasing even at low
prices other things being equal owing to the fact that so many others are also consuming the
same commodity. i.e. represents people’s desire to be exclusive or different and dissociate
themselves from the common ‘hard’.
vi. Nature of the Commodity

(a) There are some commodities (e.g. necessity goods like salt) whose demand is almost
perfectly price inelastic because of their nature. Prices changes will not affect
quantity demanded.
(b) Also for goods with no close substitute, the quantity demanded will not respond to
changes in price e.g. salt, matches.
vii. During auctions

More and more people demand for the commodity as its price is bid up.
Types of Demand
Joint/Complementary Demand
A commodity may be complementary to another so that the two are jointly demanded. The
two have to be consumed to get a particular want satisfied e.g. pen and ink, car and petrol,
stove and kerosene. In industrial location decision, for example, there is no reason why
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industrialist should not try to site his firm near firms producing complementary goods to
enjoy the ready-made market. A proprietor must look for teachers as he admits students.
Competitive demand
For substitute goods, either of the two can be used to satisfy a particular want and their
demands are in a sort of competition e.g. beef and fish, omo or surf. An increase in the
demand for one will lead to a decrease in the demand for the other.
Composite Demand
This relates to the demand for commodities that are capable of being put into many uses i.e.
they are required for two or more purposes. This applies to raw materials e.g. planks for
furniture or roofing. If the demand for a purpose changes, it will affect the price of the
commodity and the quantity available for other purposes. If the demand for furniture
increases, there will be an increase in price of planks and fewer planks will be available for
roofing.
Derived Demand
It’s a situation whereby a commodity is demanded not for its own sake but because of the
purpose it can serve. This applies generally to the demand for factors of production and raw
materials e.g. fertilizer and cement. If there is an increase in the demand for urban housing,
there will be an increase in the demand for urban land and other factors.
b. The Theory of Supply

In economics, supply is the amount of something that firms, consumers, labourers, providers
of financial assets, or other economic agents are willing to provide to the marketplace. Supply
is often plotted graphically with the quantity provided (the dependent variable) plotted
horizontally and the price (the independent variable) plotted vertically.
In the goods market, supply is the amount of a product per unit of time that producers are
willing to sell at various given prices when all other factors are held constant. In the labour
market, the supply of labor is the amount of time per week, month, or year that individuals
are willing to spend working, as a function of the wage rate. In the financial markets, the
money supply is the amount of highly liquid assets available in the money market, which is
either determined or influenced by a country's monetary authority. The study material will
focus on the supply of goods.
Difference between stock and supply: Stock is the total amount of the commodity available
with the producer. Supply is the only part of total stock which producers are willing to bring
into the market and offer sale at particular price.
Factors affecting supply

Innumerable factors and circumstances could affect a seller's willingness or ability to produce
and sell a good. Some of the more common factors are:
Good's own price: The basic supply relationship is between the price of a good and
the quantity supplied. Although there is no "Law of Supply", generally, the
relationship is positive, meaning that an increase in price will induce an increase in the
quantity supplied.
Prices of related goods: For purposes of supply analysis related goods refer to goods
from which inputs are derived to be used in the production of the primary good. For
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example, Spam is made from pork shoulders and ham. Both are derived from pigs.
Therefore, pigs would be considered a related good to Spam. In this case the
relationship would be negative or inverse. If the price of pigs goes up the supply of
Spam would decrease (supply curve shifts left) because the cost of production would
have increased. A related good may also be a good that can be produced with the
firm's existing factors of production. For example, suppose that a firm produces
leather belts, and that the firm's managers learn that leather pouches for smartphones
are more profitable than belts. The firm might reduce its production of belts and begin
production of cell phone pouches based on this information. Finally, a change in the
price of a joint product will affect supply. For example, beef products and leather are
joint products. If a company runs both a beef processing operation and a tannery an
increase in the price of steaks would mean that more cattle are processed which would
increase the supply of leather.
Conditions of production: The most significant factor here is the state of technology.
If there is a technological advancement in one good's production, the supply increases.
Other variables may also affect production conditions. For instance, for agricultural
goods, weather is crucial for it may affect the production outputs.
Expectations: Sellers' concern for future market conditions can directly affect supply.
If the seller believes that the demand for his product will sharply increase in the
foreseeable future the firm owner may immediately increase production in
anticipation of future price increases. The supply curve would shift out.
Price of inputs: Inputs include land, labor, energy and raw materials. If the price of
inputs increases the supply curve will shift left as sellers are less willing or able to sell
goods at any given price. For example, if the price of electricity increased a seller may
reduce his supply of his product because of the increased costs of production.
Number of suppliers: The market supply curve is the horizontal summation of the
individual supply curves. As more firms enter the industry the market supply curve
will shift out driving down prices.
Government policies and regulations: Government intervention can have a

significant effect on supply. Government intervention can take many forms including
environmental and health regulations, hour and wage laws, taxes, electrical and
natural gas rates and zoning and land use regulations.
This list is not exhaustive. All facts and circumstances that are relevant to a seller's
willingness or ability to produce and sell goods can affect supply. For example, if the forecast
is for snow retail sellers will respond by increasing their stocks of snow sleds or skis or winter
clothing or bread and milk.
Supply function and equation

The supply function is the mathematical expression of the relationship between supply and
those factors that affect the willingness and ability of a supplier to offer goods for sale. An
example would be the curve implied by where is the price of the good and is the price of a
related good. The semicolon means that the variables to the right are held constant when
quantity supplied is plotted against the good's own price. The supply equation is the explicit
mathematical expression of the functional relationship. A linear example is. Here is the
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repository of all non-specified factors that affect supply for the product. The coefficient of is
positive following the general rule that price and quantity supplied are directly related. is the
price of a related good. Typically its coefficient is negative because the related good is an
input or a source of inputs.
Supply curve
An example of a nonlinear supply curve
The relationship of price and supply curve. The curve is generally positively sloped. The
curve depicts the relationship between two variables only; price and quantity supplied. All
other factors affecting Supply are held constant. However, these factors are part of the supply
equation and are implicitly present in the constant term.[10]
Movements versus shifts

Movements along the curve occur only if there is a change in quantity supplied caused by a
change in the good's own price. A shift in the supply curve, referred to as a change in supply,
occurs only if a non-price determinant of supply changes. For example, if the price of an
ingredient used to produce the good, a related good, were to increase, the supply curve would
shift left.
Inverse supply equation

By convention in the context of supply and demand graphs, economists graph the dependent
variable (quantity) on the horizontal axis and the independent variable (price) on the vertical
axis. The inverse supply equation is the equation written with the vertical-axis variable
isolated on the left side: As an example, if the supply equation is then the inverse supply
equation would be.
SS = a – bP
Where SS = supply
P = price
a, b = parameter estimates
c. Price Determination
The price is the meeting point between the producer and the consumer. Unlike product that
has a positive effect on a customer being what he gains price has a negative effect – what he
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loses. Therefore it is important to set it at a right level where its negative valence is offset by
the positive valence created by the expected benefits from the product.
So that price level will be largely determined by the nature of the product and target market
characteristics.
(a) Product Benefits: as the consumer perceives it will determine the price he is willing
to pay. Example, New product will exclusive benefits not available elsewhere may
command a higher price than another without any unique benefits. But as it matures
and competition develops, price will fall.
(b) Consumer characteristics e.g. products aimed at highly sophisticated market should
command a higher price than-another aimed at law income, usually price-cognitive
market.
Price could therefore be used as a tool of creating product image which is appropriate for the
selected market segment. We have seen that regardless of the market structure within which
the firm operates, profit maximization is based on a careful analysis of the relationship
between MC and MR. Economic theory assumes the existence of a fair, unique equilibrium
price (where the demand function assumes consumer rationality, and price is determined
through the use of a formula which assumes that the nature of the relationship between
demand and price on the one hand and production and cost on the other are known). Through
the use of optimization techniques, a unique price which maximizes profit as well as clears
the market is arrived at.
This techniques is theoretical for use, the assumptions are not real e.g. demand behaviour in
relation to price is not known and so marketers have resolved to simpler and more pragmatic
pricing techniques. But in practice, research has shown that most firms set prices without an
in-depth analysis of the marginal relationship. The main objective of pricing is to arrive at a
fair, equilibrium price where the company earns a satisfactory level of profit and the
consumer obtains the best value for money spent in buying the product.
Pricing Practices/Pricing Techniques in Use

i. Cost–plus/Full Cost Pricing /Mark-up Pricing
Is the most prevalent pricing method employed by business firms. It has many varieties but a
typical one involves estimating the average variable cost of producing and marketing a
particular product, adding a charge for overhead and then adding a percentage mark up or
margin for profits.
The cost of producing the product is used as the base to which a fixed percentage mark-up is
added.
Criticism, being a naïve pricing technique

(a) It is based solely on cost considerations and fails to examine demand conditions.
(b) It emphasizes fully allocated historical accounting costs rather than MC or estimates
of future costs, future for which price is being set. Accounting costs seldom reflect
true economic costs. Opportunity / alternative cost concept must be employed for
optimal decision making.
(c) It fails to reflect competition.
(d) It is based upon circular reasoning i.e. quantity demand is determined by the price
charged and price charged is dependent upon quantity demanded.
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(e) The two objectives of pricing: profit max and Utility Max are not explicitly
considered, though might have been born in mind.
(f) Firms aim at covering TC from TR yet TC can only be covered if budgeted sales
equal actual sales. What happens if this is not the case?
ii. Target Pricing Techniques: It’s a refinement of the mark-up technique in which
company fixed a price that would enable it secure a predetermined rate of return on its total
costs. It defers from the mark-up technique in that there is the need to assume a sale volume
before the price is determine. A problem is therefore created in that price level affects sales
volume and both determine the rate of return.
iii. Competition Oriented Pricing
In a perfectly competitive economy, the individual firm is a price-taker. Each firm thus
charges the going rate price in industry. Therefore more efficient firms are able to make a
relatively higher level of profit.
iv. Scaled-bid Pricing: Pricing low in order to increase the probability of winning the job
and beating competitors i.e you guess the price the competitor is likely to quote therefore
decide to compromise the profit maximization objective by pricing low.
v. Demand-Oriented Pricing
It emphasizes consumers’ perception of a product’s benefit in money terms. This perceived
value of the product must however be sufficiently high to meet the profit objective of the
firm. Price discrimination also represents a demand oriented pricing. Discrimination may be
bases on place, person or time segmenting the day for long distance telephone. Differential
prices are charge in different markets, persons and time. Different classes of customers are
charged different prices for the same product.
vi. Acceptance Pricing: Used in a situation where a price-lender has emerged i.e. may not be
the largest firm. A firm initiates price changes and other firms merely follow the pattern set
by the leader, accepting his leadership to avoid harmful cut-throat competition.
vii. New Product pricing strategy

(a) Skimming Pricing: It is a situation where producers charge a very high price initially
to be able to cover some of the initial cost involved during the research for the
product. You may continue to charge high for a long period if your product is not
easy to duplicate or copy. But then you must reduce the price later, after some time to
make it unattractive for competitors to come in since competitors may be encouraged
to duplicate your product if you continue to charge high price.
(b) Penetrating Pricing Strategy: This involves charging low price initially, and as you
penetrate the market, you increase your price. This is possible in situations where you
are very sure of the quality of your product and you are encouraging people to come
and see how good your product is. They come, see that it is good and then when you
increase the price, they will continue to buy, then you increase again until you get the
required price level where MU = P.
viii. Psychological pricing: it is often designed to influence product image. Under this, we
have
(a) Odd-Even pricing: e.g. charging N99.90k because you want customers to still feel
that the price is below N100.00.
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(b) Multiple Unit Pricings: This is the practice of providing discount for the purchase of
two or more units of a product. i.e, quantity discount in accounting.
(c) Prestige Pricing: This involves setting very high prices on articles of ostentation i.e.
products with snob demand curve, to give an impression of high quality. Some people
will buy these products only when their prices are high. Profits are made not on the
volume but on the unit e.g. Jewelry, Luxurious cars etc.
(d) Price Lining Strategy: It involves a firm selecting a limited number of key prices or
price points for certain classes of products e.g. A departmental store might price all
her T-shirts in rows i.e. according to a scheme like N300–N350–N400-N450-N500
etc. i.e. there are ranges /rows of T-shirts with different price range under a scheme.
Conclusion
Looking at these techniques, the following should be taken into consideration where a pricing
decision is to be taken.
(a) Clear objectives must exist and price must be tailored to help meet these objectives.
(b) The true cost (its net effect on revenue) SR & LR effects of the decision (total effect)
must be known (incremental cost)
(c) The total demand situation must be analyzed.
(d) Qualitative and not just quantitative information must be considered.
(e) TR & TC must be evaluated at different price levels with varying assumption.
(f) The establishment of a price must involve the participation of the accounting,
marketing and the production departments.
ix. Factor Pricing

The mechanism of determining factor prices does not differ fundamentally from that of other
commodities. i.e. factor prices are determined in market under the force of demand and
supply. The difference lies in the determinants of the demand and supply of productive
resources. Economists in the (19th century has classified factor inputs into 4 groups: Land,
Labour, Capital and Entrepreneurship. There prices were called rent, wage, interest and profit
respectively. Each of them has been examined by a separate body of theory.
d. Price Control
e. Concept of Elasticity
There are many types of elasticity of demand as its determinants. The most important ones
are:
i. the price elasticity,
ii. Income elasticity and
iii. Cross elasticity of demand.
For decision making purpose, the firm needs to know how sensitive the demand is to changes
in the variables in its demand function. Some variables can be controlled by the firm-prices,
advertisement etc. and it is good to know the effects of altering those, if good prices and
advertising decisions are to be made. Other variables are outside the control of the firm e.g.
Consumer incomes, competitors prices. The effects of the changes in these variables must
also be (anticipated and forecasted) known if the firm is to respond effectively to change in
the economic environment within which it operates. The measure of responsiveness typically
employed in demand analysis is elasticity.
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Elasticity is the percentage change in quantity demanded attributable to a given percentage

change in any independent variable X.
Elasticity = Percentage change in Q

Percentage change in X
= ∆ Q ÷ ∆X = ∆Q × X
Q X Q ∆X
= ∆Q × X
∆X Q
Q = Quantity demand,
X = an Independent variable
∆ = amount of change in the variable
There is elasticity for each of the independent variables in the demand function i.e. there are
many elasticity of demand as its determinants but the most important ones are:
1. Price elasticity
2. Income elasticity
3. Cross elasticity.
Elasticity may be defined in two ways:
Point elasticity measures the elasticity at a given point being a proportionate change in the
quantity demanded resulting from a very small proportionate change in price. As shown
above.
Arc elasticity measures the average elasticity over some range. For many business decisions,
we are interested not in any infinitesimally small change in the variables but rather in changes
over some range of values. In this case, the arc elasticity provides the relevant measure of
responsiveness. As shown below.
Arc Ed = ∆Q ÷ ∆X = ∆Q × X2+X1
Q2+Q1 X2+X1 ∆X 2
2 2 Q2+ Q1
2
Price elasticity of demand

Is a measure of the responsiveness of demand to changes in the commodity’s own price? It
provides information about the effects of price on revenues. Depending on price elasticity, a
given change in price will result in an increase in total revenue, a decrease or no change. We
can identify five significant degrees or ranges of price elasticity at the various points of a
linear demand curve.
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i. Perfectly elastic demand:
Consumers are ready to buy all quantities obtainable at the existing price but not ready to buy
at all even at a slightly higher price.
ii. If ep = 1, the demand has unitary elasticity
e.g. One percent change in prices will lead to one percent change in quantity demanded.
iii. If ep = O demand is perfectly inelastic
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iv. If o  ep 1, demand is inelastic
5. If 1 ≥ep ≤ 00, we say that the demand is elastic
A small change in price lead to a greater percentage change in quantity demand
Determinants of Price Elasticity of Demand

i. Availability of substitutes
The demand for a commodity is more elastic if there are close substitutes for it. The closer
the substitutes for a commodity in the same price range, the more elastic the demand will tend
to be. e.g. butter and margarine. Goods with no close substitutes have low elasticity or are
inelastic.
ii. Degree of necessity / Nature of Commodity

Demands for necessities are price inelastic while demands for luxury goods are price elastic.
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iii. Uses: If commodities can be put to several uses, its demand will be inelastic
and vice versa.
iv. Time Period Demand is more elastic in the long run.
v. Proportion of Income Spend on the Commodity

The demand for a commodity whose price takes a large amount of consumer’s income
(e.g. cars) will tend to be more elastic than the demand for a commodity that consumers
can easily afford. Therefore the price elasticity of demand for automobile is higher than
that for matches.
Some Uses of Price Elasticity of Demand

In establishing price policy, firms need to be aware of the elasticity of their product. A profit
maximizing firm will never choose to lower its product price in the inelastic range of its
demand curve
Elasticity concept is useful in market structure analysis e.g. If all the firms in an industry face
highly elastic demand curves, we may assume that the industry is quite competitive, and vice
versa.
Income Elasticity of Demand

Measure the responsiveness of quantity demand to changes in income of consumer.
Q x Y
Y Q
Income and quantity purchased move in the same direction, i.e. Income and sales are directly
related to Q and hence EY are Positive for normal goods. But for inferior goods, demand
declines as income increases because consumers replace them with more expensive products.
To examine income elasticity over a range of incomes rather than at a single point, we use the
arc elasticity relationship.
EY = Q2 - Q1 × Y2 + Y1/2
Y2 - Y1 Q2 + Q1/2
This provides a measure of the average responsiveness of demand for the product Q as a
result of a change in income from Y1 to Y2
Income elasticity is useful in classifying goods into luxuries and necessities. A commodity is
considered to be a luxury if its income elasticity is greater than unity, whereas it is a necessity
if it’s in some elasticity is small (less than unity).
Main determinants of Income Elasticity:

i. Nature of the need that the commodity covers. The percentage of income spent on
food declines as income increases – (Engel’s law used as a measure of welfare and of
the development of an economy).
ii. Initial Level of Income of a Country
e.g. a TV. Set is a luxury in an underdeveloped, poor country while it is a necessity in
a developed country with high per capital income.
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iii. Time Period. Consumption pattern adjust with time-lag to change in income.
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The Cross elasticity of demand

The demand for many goods is influenced by the prices of other related goods. The two
types of relationships being, substitutes and complements. Cross elasticity of demand is
defined as the proportionate change in the quantity demanded of x resulting from a
proportionate change in the price of y.
Exy = dQx ÷ dPy
Qx Py
= dQx x Py
Qx dPy
= dQx × Py
dPy Qx
The cross elasticity for substitutes is always positive – and the sign for the cross elasticity is
negative if x and y are complementary goods. The higher the value of the cross-elasticity the
stronger will be the degree of substitutability or complementarily of and y.
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CHAPTER FIVE
5. THE THEORY OF THE FIRM
a. Division of Labour and Specialization
Division of Labour/Specialization:
Division of labour is the specialization of labour into jobs; production process is divided into
various activities / stages where workers perform different types of jobs. And so there is the
need for workers cooperation for a successful production process since each worker will
produce only a part of the product.
Merits
i. Enhances specialization in jobs of workers preference.
ii. Improves workers’ skills
iii. Saves time.
iv. Increased output at reduced cost.
v. Enhances greater use of machinery.
Demerits
i. Monotony of work
ii. Risk of unemployment with narrow specialization.
iii. Loss of craftsmanship – no pride of ownership – mere tender of machines.
Limitations
i. Size of the market
ii. There are works that cannot be divided into jobs or stages e.g. driving.
b. Location and Localization of Industries

i. Localisation of Industry
Localisation of industries is also called the geographical or territorial division of labour.
This means that certain areas or towns come to specialise in the production of certain
commodities.
Causes of Localisation of Industry

There are several factors which are responsible for certain centres specialising in certain
products. It is partly due to natural causes like climate, nature of the soil, presence of minerals
and power resources. Then, there are economic factors like the availability of labour and
capital and proximity to markers. Sometimes political factors also assist localisation by
extending patronage and restricting outside competition.
Favourable Climate
There are certain industries which require special type of climate, e.g., damp climate for
spinning and weaving. The growth of certain herbs and the preparation of medicines and
drugs from them need a temperate climate. The climatic factor is a very important one for
determining the localisation of an industry. The damp climate of Bombay specially suits the
cotton textile industry localised there.
Nearness to Raw Materials

Proximity to raw materials is an essential condition of localisation, if the raw material is
bulky. A cement factory must be near the limestone rock; the iron and steel industry must be
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located where iron-ore fields, coal-mines and abundant water are to be found in close
proximity.
Nearness to Sources of Power

For running a mill, power is necessary. The fall of a canal or a stream from a higher to a
lower level may be used to generate electricity, or coal should be available nearby.
Fertility of the Soil

Industries which are based on agriculture, like the sugar industry, the dairy industry, fruit and
vegetable canning, etc., must have vast areas of fertile land all around. It will be impossible to
establish such industries in areas which are arid wastes
Nearness to Markets
If the market is near, the cost of transportation will be low. Many foreign concerns were
established close to their consumers and save transport costs. This is the case of Ewekoro
cement factory.
Availability of Trained Labour

Some areas have traditions of inherited skill. Adequate supplies of trained labour are
available there. The employers will experience no difficulty in securing an adequate supply of
efficient labour here. This is a great inducement to the capitalists to establish their factories
there.
Availability of Capital
No business can be run and expanded successfully without adequate credit facilities at
reasonable rates. The presence of banks and financial houses in a locality encourages the
establishment of trading and industrial concerns there.
Political Patronage
Sometimes States give certain concessions like grants of free land, advances of cheap money,
subsidies, bounties, protective duties and guarantees of purchases. This attracts industries to
certain areas.
Momentum of an Early Start

Sometimes no particular cause is at the root of the location of an industry in an area. The
industry just happened to be started there by some enterprising businessman sometime back.
It grew in strength from the momentum gained from that early start. The Ludhiana hosiery
industry owes its present position to this cause.
Causes of Persistence of Localised Industries

We notice that some industries having been localised in certain areas tend to persist there
even though the original causes leading to localisation may have ceased to operate. Every
new venture in the field tends to gravitate to that particular place. The following reasons may
be given for this tendency
Trained Labour
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In no other city will a man find such an abundant supply of hosiery workers as in Ludhiana.
The factories working there serve as training grounds, and a large supply of skilled labour is
built up on which the new entrants in the industry can easily draw. This is no small attraction.
Credit Facilities
In an industrial centre, several banks are started. Ample backing facilities thus become
available. This is a great facility. In order to enjoy this facility, more industrialists are drawn
to that place.
Specialised Transport
Means of transportation may have become specialised and adapted to the needs of that
particular industry. For example, railway sidings may be made available by the railway
authorities. This facility attracts further concentration of the industry in such areas.
Subsidiary Industries
Many subsidiary industries grow up in this place. The main industry draws valuable support
from these. For example, in Ludhiana, bleaching, washing and dyeing industries have been
developed. They assist the main hosiery industry.
Industrial inertia
An industry tends to remain where it is localised, unless positive drawbacks appear in that
locality. It will even put up with small hardships and inconveniences. Man does not like to
move out, if he can help it.
Other Causes
The reputation of the place helping in publicity, publication of technical journals, presence of
training and research institutions and the existence of associations to safeguard the interests of
the local industry, etc., are the other causes on account of which the industry clings to that
place.
Advantages of Localization
i. a localized product gains reputation and thus it becomes easy for a firm to find good
market within and outside the country. On the basis of reputation, it is generally able
to charge higher prices than the products of their counterparts situated elsewhere. For
instance, the sports and leather goods manufactured in Sialkot have acquired very
good commercial reputation and it is easy to sell them at good prices.
ii. when an industry is located in a particular region, it is easy to get skilled labor of the
industry, industrial skill passes on from father to son. The children team ft almost
unconsciously.
iii. localization leads to promotion and growth of subsidiary.
iv. it results in the development of specialized research institutions.
v. it leads to the spread of fast means of communication and transport.
vi. localization encourages the development of financial facilities. When banks and other
financing cooperation find profitable field for investment in a locality, they at once
open their branches there.
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vii. localization provides opportunities both for workers and the industrialists to
understand each other and to form themselves into an organization in order to
safeguard their respective interest.
Disadvantages of Localization
i. Localization is dangerous when the demand for the localized products declines due to
the growth of foreign competition or due to the changes in the tastes of the people. In
that case there will be mass unemployment in the particular localized industries.
ii. Localization results in the economic independence of one locality on the other or of
one country on the other; if the commodity demanded is one of the basic necessities
of life, it can cause much inconvenience to the depending nations.
iii. People can learn only one type of work in a localized industry. If they wish to go to
another place, they may face difficulty in getting employment.
iv. During war, a localized industry can easily be made a target for bombardment and the
whole industry can be ruined to ashes. So it is not wise to place all eggs in one basket.
On this note, the industry should be decentralized i. e. it should be spread out in
various parts of the country so that it may not become an easy target for enemy's air
attack.
Remedies to of localisation of industries

i. Supplementary Industries
Several small industries which may assist the main industry may be established. This will
remove the risk of unemployment and lessen the severity of the depression when it conies. It
will remove the – exclusive dependence of the locality on one industry, and provide other
strings to its bow. This will also remove dependence on foreign markets or materials. The
workers will have a wider scope of employment.
ii. Decentralisation
By decentralisation is meant spreading out of industries in various regions of a country. It will
be found more economical to move an industry to other less congested centres. It will remove
some of the drawbacks’ of centralisation. Such decentralisation has been taking place in
recent times. For example, cotton textile mills have been established away from Bombay and
at other centres.
c. Perfect Competitive Market

In a market structure characterized by a large number of buyers and sellers, each of whose
transactions are so small in relation to total industry output that they cannot affect the price of
the product. They are price takers. No firm can earn above normal profits in the long run.
There is complete absence of rivalry among the individual firms. There is total absence of
influence on price and this requires the following conditions i.e. assumptions.
i. Large number of buyers and sellers, so that no single firm and buyer can influence
the working of the market since each firm in the industry produces a small portion of
the industry output and each buyers buys only a small part of the total output.
50 | P a g e
ii. Product homogeneity, which connotes that output of each firm is perceived by
customers to be precisely identical or equivalent to the output of any other firm in
the industry.
These 2 assumptions imply that each firm in pure competition is a price-taker: Its demand
curve is infinitely elastic, indicating that the firm can sell any amount of output at the
prevailing market price. The demand curve is also the firm’s Average Revenue, and its
marginal revenue.
iii. Free entry and Exit: No barrier / restrictions.

iv. Profit Maximization is the goal of all firms. No other goals are pursued.
iv. No government regulation/intervention in the markets e. g. tariffs, subsidies, rationing
v. Perfect dissemination of information
vi. Perfect mobility of factors of production. This implies that labour is not unionized,
raw materials are not monopolized, skills can easily be learnt.
d. Monopoly Market
Pure monopoly is a market structure characterized by the existence of a single producer of a
good that has no close substitute and there are barrier to entry. Pure monopoly like pure
competition exists primarily in economic theory and not in practice. Because really few are
produced by a single producer and fewer still are free from the competition of a close
substitute. Even public utilities are imperfect monopolies in most of their markets. E.g.
Electric companies typically approach a pure monopoly in their residential lighting market,
gas and oil powered private generators but face strong competition from gas and oil suppliers
in the heating market.
Price/Output Decision under Monopoly

Under monopoly, industry demand curve is identical to the firm’s demand curve and industry
demand curve is downward sloping from left to right. Monopolists can set either price or
quantity but not both. Given one, the other’s value is immediately determined by the
relationship express in the demand function. Also, monopolists operate at output where MR =
MC but MR ≥ P because demand curve is not horizontal. Monopoly may take the form of a
single producer, collusion of firms, unified business organization etc. Whatever the form it
takes, the firm must have the market for the product to itself.
Features of Monopoly:
i. There must be only one producer of a single commodity
ii. The commodity must have no competing substitute
iii. There must be strong barriers to entry of other producers.
51 | P a g e
The monopolist can make abnormal profit both in the short run and the long-run since he is
able to ward off competitors and his product has no close substitute.
- The Average Revenue (AR) curve always lie above the MR curve
- Price is determined along the demand curve therefore P = AR.
- Profit is maximized where MC = MR.
Price and output decision under monopoly market
Main causes of Monopoly include:

1. Ownership of strategic raw materials.
2. Exclusive knowledge of production techniques.
3. Patent rights for a product or for a production process
4. Government licensing / imposition of foreign trade barriers to exclude foreign
competitors.
5. Size of the market may be such as not to support more than one plant of optimal size.
i.e. the monopoly may be such as to exhibit substantial economies of scale which
require only a single plant, if they are to be fully reaped, e.g. public utilities like
Electricity, Transport, Communication.
Therefore government undertakes the production so as to avoid exploitation of the
consumers
6. Existing firm may adopt a limit pricing policy aimed at preventing new entry. The
pricing policy may be combined with e.g. heavy advertising or continuous product
differentiation to render entry unattractive.
Monopoly Control
Most common method of monopoly regulation is through price controls so that large
quantities are sold, profit is reduced.
• Controls over industry structure.
• Direct controls designed to prevent them from taking advantage of their consumers – The
antitrust laws designed to decrease industrial concentration and to prevent collusion
among oligopolistic firm.
Comparison of Pure Competition and Pure Monopoly

Similarities
i. In both markets, the goal of the firm is profit maximization
ii. Perfect knowledge is assumed in both
iii. The cost conditions in both are such as to give rise to a U-shaped cost curve in the
short and long run
52 | P a g e
iv. Profit is maximized in both when MC=MR
Differences
Perfect Competition Pure Monopoly
Homogeneous products Products may or may not be homogeneous
Large number of sellers who are price takers. Single seller who could be a price makers
Free entry and exit of firms. Entry is blocked
Demand curve is perfectly elastic Dd Demand curve is negatively sloping, D=AR but
=AR=MR=MC lies above MR.
Firms have only the output decision to make Firms can determine either Output or Price but
not both
Equilibrium is when P = MR = MC At equilibrium, P>MC, MC = MR
Earns normal profit in the long run Earns super – normal profit in the long run.
e. Monopolistic Competitive Markets

Features
It combines both features of perfect competition and pure monopoly.
i. There are many buyers and sellers but not infinite.
ii. Each produces similar but differentiated products.
iii. There is free entry and exit of firms.
iv. There are non-price competitions such as quality, wrapping, advertisement etc. so that
each firm enjoys monopoly over his own product and firms are aware of each other’s
actions.
v. The firms sometimes collude.
vi. The firm is not a passive price taker. May manipulate price and quantity until profit is
maximized.
vii. Competition is keen among firms since products are similar.
viii. The demand curve is downward slopping since products are differentiated. Some
customers will remain loyal and still buy even when price is increased. Will not loose
all customers as in pure competition.
ix. Profit is maximized when MR = MC.
x. The short-run equilibrium of the firm is the same as that of monopolist but in the long
run with free entry, the excess profit attracts new entrants, the excess profit is wiped
away and normal profits are realized.
Monopolistic market is a market structure similar to pure competition but distinguished from
it by the fact that consumers perceive differences between products of different firms. Above
normal profits are attainable only in the short run. Pure competition and monopoly rarely
exist in real life situation; rather, most firms are subject to some competition but not to the
extent that would exist under pure competition. Though most firms are faced with a large
number of competitors producing highly substitutable products, firms still have some control
over the price of their output – They cannot sell all they want at a fixed price nor would they
loose all their sales if they raise prices signify less than perfect competition.
The Theory of Monopolistic competition published in 1933 retains two assumptions of purely
competitive market structure.
(a) Large number of firms producing a particular product.
53 | P a g e
(b) Each firm makes its decision independently of all other.
The assumption of completely homogeneous products is removed. Each firm is assumed to be

able to differentiate its product to some degree those of rival firms.
Product differentiation takes many forms

i. Quality differentials
ii. Packaging
iii. Credit terms
iv. Maintenance service of eg. IBM
v. Advertising
Branding name identification so that some consumers prefer the product of one seller to that
of others, and the perfect elasticity of the firms demand curve is removed. The firm can
determine its optimal price / output combination. Strong differentiation results in greater
consumer loyalty and hence in more control over price. i.e. the more differentiated a firm’s
product, the lower the substitutability of other products for it.
Comparison between Pure Competition and Monopolistic Competition

Similarities:
1. Single objectives of profit maximization in both.
2. There are large number of buyers and sellers.
3. There is free entry and exit of firms.
4. Cost conditions are such as to give rise to U shaped cost curves.
5. Normal profits are made in the long run.
6. There is competition in both markets.
7. Equilibrium is established where MC = MR
Differences
Pure Competition Monopolistic Competition
Homogeneous products Heterogeneous / Differentiated products
Demand curve is perfect elastic Demand curve is negatively sloping
Has only output decision to make Can determine either output or price
Resources are optimally allocated Resources are misallocated since in the long
run, firms wont employ enough resources to
produce at a minimum point on the AC curve
Comparison between Monopoly and Monopolistic Competition

Similarities:
1. Equilibrium is where MC = MR
2. Demand curve slopes down from left to right and MR curve is below it.
3. Both Producers can influence price.
4. Both realize abnormal profits in the short run.
Differences
Monopoly Monopolistic Competition
One producer Few producers
No product differentiation Differentiated products
54 | P a g e
No competition Competition exists

Entry is blocked Freedom entry and exit
The only firm is the industry There are many firms in the industry
55 | P a g e
f. Mergers and Acquisitions: Advantages and Disadvantages

Mergers and acquisitions represent the ultimate in change for a business. No other event is
more difficult, challenging, or chaotic as mergers and acquisitions. It is imperative that
everyone involved in the process has a clear understanding of how the process works.
Mergers and acquisitions are now a normal way of life within the business world. In today's
global, and competitive environment; mergers are sometimes the only means for long-term
survival. In other cases, mergers are a strategic component for generating long-term growth.
When we use the term "merger", we are referring to the coming together of two or more
companies where one new company will continue to exist. The term "acquisition" refers to
the taking over of assets of one company by another company. In an acquisition, both
companies may continue to exist but the commonest scenario is that the acquiring company
will remain in business and the acquired company (which we will sometimes call the Target
Company) will be integrated into the acquiring company.
Every merger has its own unique reasons why the combining of two or more companies is a
good business decision. The underlying principle behind mergers and acquisitions (M&A) is
simple: 2 + 2 = 5. The value of Company A is N2 billion and the value of Company B is N2
billion, but when we merge the two companies together, we have a total value of N5 billion.
The joining or merging of the two companies creates additional value which we call
"synergy" value.
Mergers can be categorized as follows:

Horizontal: Two firms are merged across similar products or services. Horizontal mergers are
often used as a way for a company to increase its market share by merging with a competing
company. For example, the merger between Exxon and Mobil will allow both companies a
larger share of the oil and gas market.
Vertical: Two firms are merged along the value-chain, such as a manufacturer merging with a
supplier. Vertical mergers are often used as a way to gain a competitive advantage within the
marketplace. For example, Merck, a large manufacturer of pharmaceuticals, merged with
Medco, a large distributor of pharmaceuticals, in order to gain an advantage in distributing its
products.
Conglomerate: Two firms in completely different industries merge, such as a gas pipeline
company merging with a high technology company. Conglomerates are usually used as a way
to smooth out wide fluctuations in earnings and provide more consistency in long-term
growth. Typically, companies in mature industries with poor prospects for growth will seek to
diversify their businesses through mergers and acquisitions. For example, General Electric
(GE) has diversified its businesses through mergers and acquisitions, allowing GE to get into
new areas like financial services and television broadcasting.
Advantages Disadvantages
It will give rise to higher revenue It will lead to job losses
It leads reduced cost of capital The area of competence of the acquired company is lost
Better positioning for future market Expansion will lead to short run cost increase
Organisational competencies
Broader market access
56 | P a g e
57 | P a g e

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Principles of Economics (MPE 007)

Nigerian Institute of Management (Chartered)

VISION: To be the Source and Symbol of Management Excellence

We also appreciate the support provided by the Directorate of Capacity Building.

Theory of Consumer Behaviour....................................10 – 14

Production Cost and Theories.......................................15 – 28

The Theory of the Firm...................................................42 – 51

Criticism of Adam Smith definition

ii) Welfare Definition

a) Economics is a study of mankind in the ordinary business of life, i.e., economic

Criticisms of Alfred Marshall definition

b) Marshall makes a distinction between

However, generally, welfare means happiness or comfortable living conditions of an

iii) Welfare Definition

Criticisms of Robins definition

while production of alcoholic drinks is not conducive to human welfare. However,

iv) Growth Definition

The major implications of this definition are as follows:

i) Economics - A Science and an Art

Economics (A Social Science): In order to understand the social aspect of economics, we

ii) Positive and Normative Economics

iii) Methodology of Economics

iv) Subject Matter of Economics

a) Traditional Approach: Economics is studied under five major divisions namely

4. Distribution: The production of any agricultural commodity requires four factors,

b. Basic Economic Concepts of;

v. Choice: Since we are unable to have everything we desire, we must decide on

Managerial Economics and Business Decision Making

Traditional Economic Theory Business Administration

Managerial Economics: Application of Economic Theory

Scope of Managerial Economics

Uses and Applications of Managerial Economic

d. The Economic System and Basic Economic Problems of Society

The basic economic problems of an economy can be given as follows:

ii) How to produce?

iii) For whom to produce?

iv) Efficiency of Production

a. The Cardinalists Approach (Utility Concept)

Assumptions of Cardinal Utility Analysis

Law of Diminishing Marginal Utility

b. The Ordinalists Approach (Indifference Curve Concept)

Appraisal of the Indifference Curve Approach

Applications of Indifference Curve Analysis

The properties of production functions can be graphically examined by means of isoquants.

Substitution of Input Factor

(a) In some production system, input substitution or replacement is readily accomplished

Gas Perfect Substitution

Frames inputs are perfect complements

The substitutability of A for B diminishes as we move from point A to B in the figure

Marginal Rate of Substitution

Returns to scale and returns to factor

Concepts of Total, Marginal, and Average productivities

When MP is positive, TP increases, though at a decreasing rate. At Q=100, MP=0 & TP is

Law of Diminishing Returns:

Diminishing returns to constant factor

Merits and demerits of division of labour

Enhances specialization in jobs of workers Monotony of work

Limitations of division of labour

i. Size of the market